Swedroe: The Best Approach To ‘Value’
It’s well documented in the academic research on stock returns that value stocks have outperformed growth stocks. And we see the higher returns to value stocks in almost all countries. And not only has value outperformed growth, but the persistence of its outperformance has been greater than the persistence of stocks outperforming bonds.
When implementing a value strategy, many different metrics can be used. Among the most common are price-to-earnings, price-to-sales, price-to-book value, price-to-dividends and price-to-cash flow. All the various approaches produce results showing that value stocks have had higher returns than growth stocks. And the various measures produce similar results, with the weakest results coming from the use of the dividend-to-price ratio.
Given the similarity in results, the price-to-book ratio has been used the most because book value is more stable over time than the other metrics. That helps keep portfolio turnover down, which in turn keeps trading costs down and tax efficiency higher.
Recently, some passively managed funds have moved away from the single-screen metric, as their research indicates that using multiple screens produces better results. Bridgeway and Vericimetry are two examples of fund families that have adopted this approach. In addition, the funds based on the RAFI indexes also use multiple screens (sales, earnings, dividends and book value).
In other words, the search for the best metric to use when implementing a value strategy continues.
To help us out, let’s look at what the authors of the 2012 study “Analyzing Valuation Measures: A Performance Horse-Race Over the Past 40 Years,” found. They covered the 40-year period 1971-2010 examined the returns to a variety of value metrics:
- Earnings to Market Capitalization (E/M)
- Earnings before interest and taxes and depreciation and amortization to total enterprise value (EBITDA/TEV). (Total enterprise value is defined as market capitalization + short-term debt + long-term debt + preferred stock value – cash and short-term investments.)
- Free cash flow to total enterprise value (FCF/TEV)
- Gross profits to total enterprise value (GP/TEV)
- Book to market (B/M)
- Forward earnings estimates to market capitalization (FE/M)
Following is a brief summary of their findings:
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